Most investors are not experts in mutual fund analysis. They probably don't know what a Sharpe ratio is or why one provider charges 175 basis points for Fund XYZ and another only charges 25 for Fund ABC. The majority of investors aren't trained in fundamental analysis and don't know how to read a candlestick share chart. Most investors are just looking for a relatively safe place to save their money and hope to earn a decent return along the way, and that's why ratings companies such as Morningstar, Inc. (NASDAQ: MORN) and Lipper, Inc. are so important.
Morningstar and Lipper are two of the most prominent names in the mutual fund world. These companies evaluate funds, highlight critical data and award a simple, easy-to-compare rating to each of them. Mutual fund companies care about their Morningstar and Lipper ratings because they know so many investors and financial advisors rely on them to make investment decisions.
Morningstar's most popular evaluation metric is its five-star scale. Lipper uses five separate quintiles, or categories, and rates each fund across five different measures. If a fund is determined to be in the top 20% in a specific quintile, it gets the title of "Lipper Leader" for that feature.
Morningstar and Lipper ratings are widely published, so many people accept them as accurate. A better approach would be to understand the strengths and weaknesses of each ratings system.
The first Morningstar Rating was introduced in 1985. It focused on a few broad categories and was more of a data accumulation resource than a comprehensive evaluation.
The entire system was overhauled in 2002. New fund categories were incorporated, and groups were narrowed to emphasize differences other than management styles. It included new metrics, and it broke performance history into different time periods. Equity funds were segregated by market capitalization (the size of the equities in the fund) to prevent large-cap funds from consistently dominating the ratings.
Today, Morningstar organizes mutual funds based on the types of investments in a fund portfolio, the region where fund investments are made and the overall management strategy. Morningstar Ratings are based on a bell curve distribution: 10% receive a 5-star rating, 22.5% receive a 4-star rating, 35% receive a 3-star rating, 22.5% receive and 2-star rating and 10% receive a 1-star rating. Morningstar updates its rankings monthly.
Lipper rates mutual funds according to five sets of criteria: consistency of return, preservation of capital, expense ratios, total return and tax efficiency. Lipper lists all five ratings for any given mutual fund and lets investors decide which is most important to them.
Each category is assigned a rating on a scale of one to five. For example, mutual fund could be rated a two when it comes to consistency of return and a five on tax efficiency. In the Lipper system, smaller numbers are considered better; a mutual fund would rather be a three than a four.
Any fund listed in the top 20% for a given category receives the title of Lipper Leader. It is possible for a mutual fund to have multiple Lipper Leader categories; in fact, many top funds have three or four Lipper Leader designations.
Lipper ratings are also adjusted every month and, just like Morningstar, are calculated for three-year, five-year and 10-year periods. Lipper also throws in an overall period that dates back to a mutual fund's inception.
The core of a mutual fund rating system is built around risk-adjusted measures – how much potential for future losses an investor has to assume in order to earn a return.
For both Morningstar and Lipper, the risk-adjusted measure is based on a comparison to the average performance for a given fund category. This means that a mutual fund will look good or bad based on how well its returns and losses correlate with basic indexes for the category. For example, large-cap funds are measured against a major large-cap index, such as the S&P 500.
There's a lot of potential for error in a system such as this, since merely being different than an index could lead to artificial improvements in fund rating. A 75% mid-cap fund might be compared to a major mid-cap index, but its 25% exposure to small caps could boost returns enough to give it a ratings boost, regardless of the performance of the manager.
This is particularly problematic for Lipper, which uses an information ratio in its calculation that is overly sensitive to choice of index. Morningstar suffers from this problem to a lesser extent. Investors should pay close attention to the level of difference between a mutual fund and its comparative index. R-squared is an excellent gauge for those who follow modern portfolio theory (MPT).
Categories and index choices greatly influence the Lipper and Morningstar ratings, which means that it's important to understand how funds are assigned to different categories.
In the United States, Morningstar supports 110 categories, which map into nine category groups (U.S. equity, sector equity, allocation, international equity, alternative, commodities, taxable bond, municipal bond, and money market).
Lipper blends its mutual funds based on both classifications (which are holdings-based) and categories (which are based on the fund objective language in the prospectus). Lipper has seven separate global equity classifications based on investment style and market capitalization; Morningstar supports seven different diversified international stock categories (Foreign Large Value, Foreign Large Blend, Foreign Large Growth, Foreign Small/Mid Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, and World Stock.)
Even though there are significant methodological challenges with both Morningstar and Lipper, these are still viable and helpful tools for the investing public. Not everyone has the time to become an expert in fund analysis, so it is very desirable to have companies such as these to simplify things.
Morningstar gains the edge in transparency, simplicity and effective risk measurements. Lipper is better on customization, depth and tracking persistent performance among like-funds. Investors should keep in mind that past performances – what these systems are based on – are not guarantees of future results, and every investment should match an individual investor's specific needs and goals.